In 2010, two Harvard economists published an academic paper that spoke to the world’s biggest policy question: should we cut public spending to control the deficit or use the state to rekindle economic growth? “Growth in a Time of Debt” by Carmen Reinhart and Kenneth Rogoff has served as an important intellectual bulwark in support of austerity policies in the US and Europe. It has been cited by politicians ranging from Paul Ryan, the US congressman, to George Osborne, the UK chancellor.

The Reinhart-Rogoff research is best known for its result that, across a broad range of countries and historical periods, economic growth declines dramatically when a country’s level of public debt exceeds 90 per cent of gross domestic product.

In other words, it was argued by Reinhart- Rogoff that high debt essentially meant that the state captured all resources, used them inefficiently, prevented the private sector using them and so curtailed growth at cost to everyone.

The erros made are threefold. First, the Reinhart-Rogoff spread sheet used to reach the conclusion simply didn’t add up. Second, they used a bizarre weighting system that have one off singular adverse events equal weighting to many years of normal events, and thirdly they omitted some data for reasons that have not been disclosed. All are pretty fundamental methodological errors. The first is every data users nightmare, but is why you always double check – which is tedious but necessary. The second and third are much harder to explain. But the implications are clear:

In their work [Reinhart-Rogoff] with a sample of 20 advanced economies over the postwar period, they report that average annual GDP growth ranges between about 3 per cent and 4 per cent when the ratio of public debt to GDP is below 90 per cent. But average growth collapses to -0.1 per cent when the ratio rises above a 90 per cent threshold.

But as Pollin and Ash note:

In a new working paper, co-authored with Thomas Herndon, we found that these results were based on a series of data errors and unsupportable statistical techniques.

When we performed accurate recalculations using their dataset, we found that, when countries’ debt-to-GDP ratio exceeds 90 per cent, average growth is 2.2 per cent, not -0.1 per cent. We also found that the relationship between growth and public debt varies widely over time and between countries.

So far from stopping growth, high debt may at best impair growth a little, and without consistent evidence that it is debt that is the causal factor at all. As they note:

Consider a situation in which a country is approaching the threshold of a 90 per cent public debt/GDP ratio. It is not accurate to assume that these countries are reaching a danger point where economic growth is likely to decline precipitously.

Rather, our corrected evidence shows that a country’s growth may be somewhat slower once it moves past the 90 per cent public debt-to-GDP level. But we cannot count on this being true under all, or even most, circumstances.

As they point out, circumstances other than debt have also to be considered. The Reinhart-Rogoff result was just too simplistic, as well as being wrong. But the most important conclusion is this:

What about our present circumstances? Using Prof Reinhart’s and Prof Rogoff’s data, we found that for the years 2000 to 2009, the average GDP growth rate for countries carrying public debt levels greater than 90 per cent of GDP was either comparable to or higher than those for countries whose public debt/GDP ratios ranged between 30 and 90 per cent.

In other words, the debt obsession could be completely wrong. And they explain why:

Of course, one could say that these were special circumstances due to the 2007-9 financial collapse and Great Recession. Yet that is exactly the point. When the US and Europe were hit by the financial crisis and subsequent collapse of private wealth and spending, deficit-financed government spending was the most effective tool for injecting demand back into the economy. The increases in government deficits and debt were indeed historically large in these years. But this was a consequence of the crisis and a policy tool for moving economies out of the deep recession. The high levels of public debt were certainly not the cause of the growth collapse.

As they conclude:

We are not suggesting that governments should be free to borrow and spend profligately. But government deficit spending, pursued judiciously, remains the single most effective tool we have to fight against mass unemployment caused by severe recessions. [More] [r]ecent research by Prof Reinhart and Prof Rogoff, along with all related arguments by austerity proponents, does nothing to contradict this fundamental point.

Pollin and Ash don’t want to say that the debt obsession is wrong, per se, and of course in extremis they’re right. But the simple fact is that we are so, so far away from extremis (UK debt being lower right now than for most of the last two centuries) austerity for debt reduction makes absolutely no sense at all. That is what we can conclude from this. Which means it’s time to spend. As I’ve long argued.

25 Responses to “When economists are wrong we all suffer. And we now know the debt obsession is wholly misplaced”

“We are not suggesting that governments should be free to borrow and spend profligately”

Isn’t that a matter for the electorate, rather than an unelected cabal who have proved beyond doubt that they are significantly short of the required ‘Wisdom of Solomon’?

In a representative democracy the people should be able to elect a government that blows the system apart if they wish. The elected government must get its Finance Bill as approved by the elected parliament.

Otherwise it isn’t a representative democracy.

It’s an autocracy with a ‘safe play area’ where the ‘children’ can pretend to do democracy.

Keynes was proved right on this issue back in the 1930s. While spending is so severely depressed, there can be and never will be any real economic growth until there is sufficient stimulus, usually by the government, to get the economy moving again. The excuse for the government to massively borrow and spend was because of “lost savings” and the need of government stimulus to make up for those “lost savings”.

I have mentioned this before and I am going to mention it again. After World War II, the government borrowed at the unprecedented level of 250 percent of GDP. The money was spent on vital infrastructure; road, rail, rebuilding bombed out cities, the cretion of the NHS and the welfare state.

This profligate borrowing did not lead to a collapse of the economy or hyperinflation. In fact, the economy boomed and inflation stopped relitavely low.

It is perhaps no coincidence that with the gradual dropping of borrowing to GDP since the 1960s, The UK economy has got progressively worse.

Borrow and spend, build up real wealth such as infrastructure and manufacturing and then pay back the debt with the money earned. Cut AFTER the economy is booming if you need to, not before!

The government doesn’t even have to borrow to spend, it can just create and spend. Providing the new money is replaced with comparitive appropriate wealth (schools, hospitals, roads etc) there’ll be no inflation. The definition of wealth might be considered to be elastic which itself could give rise to plenty of scope for more money creation.

Of course it can. Notie how the government has no qualms about printing money when it’s used to get the banks out of a jam they themselves created, yet will not countenance it for spending on the real, everyday economy where it would do the most good.

Good MMT point. A sovereign government like the UK, never has to borrow (or for that matter, tax) in order to fund spending it’s own currency. The main purpose of taxation by fiat of course to give value to said currency that is issued by fiat.

NB: The ‘public sector borrowing requirement’ is a completely misleading term that actually denotes the annual amount of new savings in, what is essentially, a great big savings account that the government offers to the private sector.

Nearly all pro-austerity academic work seems to start from two axioms:
First is the hypothesis that public borrowing crowds out private investment.
Government is considered a black hole into which money (tax or borrowing) simply disappears. But this is absurd. When the Government receives money, it spends it. When it makes social payments to the poorest members of society, that money is immediately spent again, creating jobs and increasing company profits. When it builds bridges and schools, it again provides jobs and company profits.
The second axiom is that private investment is inherently beneficial. All I can say is that for many years I was a trustee of a fair-sized pension scheme and we never received the slightest encouragement to invest in any useful way. Indeed, we were continually advised to invest unproductively and that there would be danger of breach of trust if we took any account of the effect of our investments. Richard has written well on this subject.
I sometimes want to scream that it DOESN’T MATTER who spends the money. What counts is THAT the money is spent and HOW the money is spent. Austerian economics starts from a completely irrelevant distinction. The formal equivalent of arguing that money spent by men is useful, and money spent by women unproductive.
If a fraction of the effort spent arguing that the Government should spend less money was spent considering how to spend it more usefully…
(PS Richard, do you know of any work linking the Wilkinson/Pickett Spirit level to formal economics? It seems to me intuitive that money should flow more easily in a relatively equal society. Transactions between a small number of very rich and a large number of very poor can have very little impact on the economy. Has this been studied?)